Undercollateralized DeFi Loans: DeFi’s Credit Revolution or Illusion?

Blockchain’s most successful use case is decentralized finance (DeFi). DeFi has replicated many core services of traditional finance (TradFi), including stablecoins that compete with global banking and foreign exchange. However, it still struggles with its credit system—specifically, undercollateralized DeFi loans—which could be the missing piece needed to mainstream DeFi.

This article explores how credit systems work in TradFi and DeFi, the innovations progressing DeFi lending, and whether they’re sustainable in the long run. 

Credit systems in TradFi 

Traditional credit systems have evolved from mechanisms that favor the wealthy to data-driven models that assess an individual’s creditworthiness. Lenders now rely on financial records to determine a borrower’s ability to repay a loan.

However, these systems have flaws, including data security risks and limited access to quality credit services. Centralized databases are vulnerable to breaches, and many people remain excluded from the best credit options. Interestingly, some DeFi implementations, such as web proofs, suggest that decentralized systems may eventually solve the data security issue. Fixing the accessibility challenge, however, is a major focus of DeFi transactions. 

Credit systems onchain

DeFi eliminates the need for trust through automation, with smart contracts enforcing transactions without intermediaries. This approach eliminates human bias and ensures transparency. However, it raises a fundamental question: why lend money to someone you don’t trust? (at least to an extent)

Traditional credit relies on trust and risk assessment, which is why many DeFi lending protocols, like Aave, compensate with over-collateralization. Borrowers must deposit more collateral than they borrow to ensure lenders don’t lose money even if the borrower defaults.

While this system has worked, it limits DeFi’s potential. If DeFi lending is to expand, it must improve beyond over-collateralization. Some platforms, like Accountable and Credora, provide data to help DeFi applications offer un(der)secured crypto loans, but issues persist. For example, pseudonymity allows borrowers to maintain multiple identities, complicating risk assessment.

The difficulty of tracking creditworthiness in crypto was a key factor in the Alameda-FTX collapse in 2022. Since only Alameda and FTX had complete visibility of their financials, they could execute a large-scale misrepresentation, which snowballed into an even bigger crisis. 

A novel attempt at on-chain undercollateralized credit: Wildcat

Wildcat takes a different approach to making undercollateralized DeFi loans viable. Instead of over-collateralization, the protocol assesses borrowers’ credibility while leaving counterparty selection to the lenders. In the event of a dispute, Wildcat relies on traditional legal systems—an approach that has sparked skepticism but also signals crypto’s increasing integration with the real world. 

Here’s how it works: after being verified by the Wildcat team, borrowers create lending vaults with predefined terms, including interest rates. Borrowers then vet lenders before granting them access. Lenders deposit assets into the vault and receive “market tokens” representing their principal and interest. When they want to withdraw, they burn the corresponding market tokens.

The protocol continues to evolve. An upgrade introduced hooks that modularized Wildcat’s architecture, improving counterparty selection. Now, borrowers can automatically approve lenders based on credentials rather than manually vetting each. Additionally, the protocol shifted from perpetual-duration loans (which allowed lenders to withdraw anytime) to time-locked loans, where borrowers set fixed loan terms and minimum deposit requirements.

Is Wildcat the hero of undercollateralized DeFi loans?

Not quite. Not yet. While Wildcat offers a fresh take on un(der)secured crypto loans, risks remain. Since loans aren’t overcollateralized, borrowers’ defaults are still a concern. Lenders must assess available data for borrowers’ reputations, risk strategies, and track records, but reputation systems and proof-of-reserve dashboards are not foolproof.

Smart contract vulnerabilities also pose risks. Though permissioned, Wildcat is still part of DeFi, which has a history of exploitation. To address this, Wildcat has integrated with the on-chain security solution SphereX, which enhances security by verifying function calls within the protocol. Additionally, the protocol has undergone audits and public security reviews. However, as past incidents have shown, even rigorously audited platforms can suffer attacks.

Conclusion

While models like Wildcat offer alternatives, sustainable undercollateralized DeFi lending remains uncertain. Reputation-based lending, legal enforcement, and better security help, but trust, risk, and regulation challenges remain. Finding the right balance between decentralization and risk management will be key to building a more resilient DeFi credit system.

For more insights into the challenges and innovations in undercollateralized DeFi loans, refer to the original version of this article, which was first published here.